Entities taxed as a partnership -- which typically includes multi-member limited liability companies that have not elected to be treated as a corporation -- are subject to specialized audit rules for federal tax purposes. Most partnerships with more than 10 partners are subject to the “TEFRA” audit rules. Partnerships with less than 10 partners often elect into the TEFRA audit rules. Partnership agreements -- or LLC operating agreements -- ordinarily include elaborate tax matters sections that follow the TEFRA audit rules. Under the TEFRA audit rules, tax adjustments are determined at the partnership level in a single administrative proceeding. At the conclusion of the audit, the IRS must recalculate the tax liability of each partner and assess any additional tax to each partner. The IRS was not overly fond of the TEFRA audit rules and complained that the rules acted as an audit deterrent.
The Bipartisan Budget Act of 2015 (the “Act”) will eliminate the TEFRA audit rules and replace the old rules with streamlined procedures. Under the new partnership audit procedures, the IRS will continue to perform audits at the partnership level. However, any addition to tax will be determined at the partnership level and not the partner level. The Act does allow a partnership to elect to make an alternative partner-level adjustment. Although, the effect of the election is that the partnership will have to issue new K-1 statements to reflect the audit adjustments and does not equate to forcing the IRS to determine partner-level adjustments.
Somewhat similar to the procedures for designating a “tax matters partner,” the new partnership audit rules allow a partnership to designate a representative that is a partner or other person with a substantial U.S. presence. If no person is designated, the IRS will select a partnership representative.
The new partnership audit rules will apply to tax years beginning after December 31, 2017. As a result, partnerships will likely need to examine existing partnership agreements to assess whether the tax matters provisions which address partnership audits need to be modified. In addition, beginning in tax years after 2017, partnerships which are under IRS audit will face new audit procedures that substantially change how additions to tax are assessed. The byproduct of the new audit rules is that the IRS may expand the number of partnership audits.
For more information please contact Peter J. Kulick in our Lansing office at (517) 487-4279.